Home > News > 2001 > August 2001 > Tax-efficient opportunities available through stakeholder pensions
Tax-efficient opportunities available through stakeholder pensions
The dawn of the new tax year heralded in a veritable cornucopia of changes to the UK legislation affecting defined contribution ("DC") pension arrangements which are approved for taxation purposes under chapter IV of part XIV of the Income and Corporation Taxes Act 1988.
Such pension arrangements include personal pensions effected after 30 June 1988 and the new, much-publicised stakeholder pensions, which have been available from 6 April 2001. However, retirement annuities (sometimes referred to as "Section 226 Policies") effected before 1 July 1988 are not included within the new DC tax regime.
Fortunately, the legislative changes referred to above have brought with them a number of potential pension and tax planning opportunities for individuals and some of these are summarised below. If you are interested in exploring any of these opportunities further, then please speak to either your usual Barnett Waddingham consultant, or alternatively your accountant or independent financial adviser.
Take advantage of some basic stakeholder rules
- You do not need to be earning in order to contribute to a stakeholder pension.
- Those who are eligible to take out a stakeholder pension can contribute up to £3,600 (gross) in every tax year without any evidence of earnings. Higher contributions may be possible, depending upon your age and, where applicable, your current or past earnings.
- It is possible to take out a stakeholder pension for a child, with effect from the day that they are born! This can be done by anyone, not just by the child's parents and/or grandparents. Tax relief is given at source to the child's stakeholder pension. Please bear in mind, however, that the child cannot access the fund within their stakeholder pension until they are aged at least 50 (it is true that some parents or grandparents may view this as a distinct advantage!).
- Employers can pay into a stakeholder pension on behalf on an employee. This is defined as a business expense to offset against the employer's tax bill.
- Individuals who are active members of an occupational pension scheme may be eligible to top up their overall pension benefits with a stakeholder pension. It is still possible to top up your pension via the payment of Additional Voluntary Contributions (AVCs); however, the potential to take 25% of the stakeholder pension fund in the form of tax free cash may make this route a more attractive option, as under current legislation this is not an option under most AVC schemes.
- Pensioners can take out a stakeholder pension in their own name, provided that they are not aged over 75 years of age. As all contributions to personal pensions are now paid net of the basic rate of income tax with effect from 6 April 2001, individuals can pay up to £234 a month without evidence of earnings and have £300 per month credited to their stakeholder pension scheme immediately. For pensioners who may have recently retired, past certified earnings could substantiate even higher contributions; and directors of limited companies may prefer to take dividends rather than a salary from their company, possibly because National Insurance contributions are not payable on dividends. This can cause problems where directors are members of occupational pension schemes as the maximum pension provision via such schemes is set by the level of earned income, which does not include dividend payments. However, because previous certified earnings can be used to determine pension provision via a stakeholder pension, it is possible in the new DC tax regime for directors to take dividends in five out of every six years, with only one year's earnings taken to substantiate the stakeholder payments.
Case studies
The following four case studies serve to expand upon some of the basic rules set out above and aim to illustrate how the new DC tax regime can be utilised advantageously.
Case study one: spouse's pension
Louise is 30 and is an employee of her husband, Colin, who is a sole owner of a manufacturing company. For the tax year 2001/02 she earns £86 per week and so pays no tax or National Insurance contributions. In addition, her husband's company does not pay employer National Insurance contributions in respect of her earnings either.
The opportunities available
- From 6 April 2001 Louise, as a low earner who isn't a controlling director, will be eligible for Concurrent Executive Pension and stakeholder pension (or personal pension) contributions.
- Colin's company contributes £1,500 a year into an Executive Pension Plan set up for Louise. The company can also contribute £300 a month to a Stakeholder Plan for Louise and so reduce its corporation tax bill because its profits are reduced; and
- An additional benefit is that from April 2002, Louise will qualify for the new State Second Pension because her earnings are above the lower earnings limit, which for 2001/02 is £72 per week. As a result, she is likely to be treated as though her earnings are approximately £11,000 a year, meaning that she could build up a significant State Second Pension entitlement.
What are the benefits?
- Colin's company can contribute more than Louise's salary.
- Louise is building up significant pension benefits from three sources.
- The pension funds grow in a tax efficient environment, Louise can take up to 25% of the stakeholder pension Fund as tax free cash when she retires and in addition will be able to take cash from the Executive Pension Plan and the stakeholder pension benefits will not count towards the Executive Pension limits; and
- If Louise should die before drawing the benefits, the fund should be returned free of inheritance tax.
Case study two: the child
Maureen has recently retired and would like to provide financial security for her grandson James who is currently aged 10 years old. She therefore decides to pay £234 each month into a stakeholder plan in order to give James a head start in planning for his retirement.
What are the opportunities?
- James's father can take out a stakeholder pension on his behalf and Maureen can pay into this plan as long as James's father is aware of the payments; James's father is responsible for the plan until James reaches 18, when he takes control of it himself; and
- James's father can make a nomination of who should receive the benefits if James should die before reaching age 18. He can choose to nominate himself as a possible beneficiary.
What are the benefits?
- James has effectively started his pension provision early and assuming investment returns average 2% above earnings inflation (after charges), a pension payment made at age 10 is worth twice as much in real terms as an equivalent payment made at age 45;
- Payments into James's plan are made after the deduction of basic rate tax relief; therefore, the £300 a month payment only costs Maureen £234;
- Payments made by Maureen potentially count as gifts for inheritance tax purposes. However, if she pays a regular £234 a month out of her income and this does not impact on her standard of living, it could qualify as "normal expenditure out of income" and so be exempt. In addition, every individual has an annual inheritance tax exemption of £3,000. The annual equivalent of £234 a month does not breach this exemption limit.
Case study three: the retired
Stephen will retire on 1 May 2001 aged 65. Over the years he has contributed to a personal pension and has a retirement income of £50,000 a year after tax, which is paid via an income drawdown arrangement. The £50,000 per annum represents the maximum income that Stephen is allowed to take. He estimates he will need £40,000 per annum after tax to live on.
What are the opportunities?
- Stephen is eligible to take out a stakeholder pension plan and pay in £234 a month net of basic rate tax relief;
- Although Stephen's earnings have officially ceased, he can still contribute 40% of his "basis year earnings" in each tax year. The basis year can be either the tax year in which he retired or any of the previous 5 tax years. His basis year earnings can be used to justify personal pension payments for the last year with earnings and the next 5 tax years;
- If the basis year earnings amount to £32,051, Stephen could pay £12,820 gross (that is: 40% of £32,051) into a stakeholder pension plan. Basic rate tax relief is given at source so the net contribution would be £10,000. As a higher rate tax payer he will also be able to claim £2,308 further relief in his tax return.
What are the benefits?
- Stephen can now continue to contribute to a pension using the income from his income drawdown arrangement;
- As he is a higher rate tax payer, he will receive up to 40% tax relief on his stakeholder pension contributions - 22% immediately as premiums are paid net of basic rate tax and the balance via his self-assessment tax return;
- Stephen can pay based on his earnings near retirement for 5 years and then, if he has no further earned income, he can continue to contribute £234 a month (£300 per month after basic rate tax relief is added). He could, if it was appropriate for him to do so, reduce his income drawdown pension to less than the maximum at this time;
- His new personal pension fund will, when vested, produce a further 25% of tax free cash; and
- Should Stephen die prior to starting benefits from his new stakeholder pension plan, the proceeds should not attract inheritance tax.
Barnett Waddingham, August 2001.